In: Root » Legal and finance » Loans and mortgages
The interest rates on adjustable-rate mortgages, or ARMs, adjust. They can change. Fortunately there’s a rhyme and a reason regarding when and how much they change. There are ARMs that change twice per year, once per year, once per month, and so on. The ARM will have those preset change options built into the note, and those change options are called the index, margin, and cap. An index is the benchmark the interest rate on the adjustable-rate mortgage is associated with or tied to. Common indexes are the interest rates on the one-year Treasury bill or a six-month CD, but the index can be mostly whatever the lender wants it to be. Other indexes are the prime rate, the six-month Treasury bill, and the London Interbank Offered Rate, or LIBOR. The second component of an ARM is the margin. Think ‘‘profit margin’’ and you’ll get the idea. The lender adds the margin to the index to arrive at the loan’s interest rate. For example, consider an ARM based on the interest rates on the six-month Treasury bill. That rate, which can fluctuate with the economy, could be 3.61% on the date the loan is set. Next add the margin—a common one is 2.75%—to the 3.61% index rate for a total 6.36% interest rate on the loan. The adjustment period is another feature of an ARM. This is the exact date that the loan’s interest rate can adjust. The lender recalculates the rate by taking the index at the time of adjustment and adding the margin. Often the adjustment time coincides with changes in the index itself. For example, if the index is a one-year Treasury bill, then the loan might adjust once per year, every year. For a six-month CD index, the rate might adjust every six months. But it doesn’t necessarily follow with all ARMs; it’s just how most are calculated. But what happens, you may ask, if the index goes from 2.50% in year one to 10.00% in year two? Big changes in payment, right? Wrong. Built into the ARM are neat things called adjustment caps or caps. A cap protects the client from an index’s mood swings by limiting the degree to which a loan’s interest rate can change. Most caps prohibit a loan’s interest rate from changing more than one percent every six months or 2 percent per year. But not all are that way. Government ARMs, for example, have a one-percent cap every 12 months. Here’s an example. Let’s assume that $200,000 30-year loan has an adjustable rate. If the index on which the loan is based started at 2.00%, by adding a 2.50% margin, the mortgage rate is a whopping 4.50%. That works out to a monthly payment of $1,013. Now let’s assume weird things happen over the next year and the index rises significantly to 10.00%. Add the 2.50% margin and the new loan rate is 12.50%, resulting in a new monthly payment of $2,134 per month— more than twice what the borrower was paying. But if there is an adjustment cap of two percentage points, the interest rate on the loan can never go more than two percentage points higher or lower than the previous year’s rate. So even though the ARM wanted to go to 12.50%, due to the cap, it couldn’t. It could only go up two percent, or to 6.50%. Now the payment adjusts to $1,264. It’s higher than before but nothing like what your borrower would have had without an adjustment cap. Another cap friend is the lifetime cap, which dictates the highest interest rate the loan can ever carry. Most lifetime caps are 6.00% over the rate you started at, so in this example the maximum rate would never be higher than 4.50% _ 6.00% , or 10.50%. Yeah, that’s high, but because of the two-point annual adjustment cap, it will take at least three years to get there.
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